Perpetual takes diversified high yield to retail

To coincide with the launch of a new credit income trust by Perpetual Investments (Perpetual), Michael Korber, head of credit and fixed income, and Anne Moal, senior high-yield analyst at Perpetual in Sydney, share their views on the state of play in the fixed-income market. The new trust provides investors with monthly income by investing in a diversified pool of credit and fixed-income assets.

Persistent low rates and spreads have helped bring high-yield debt into focus. But why do you think this is the right time to take a new product offering to the listed investment-trust space?

KORBER This is a very good time to offer investors access to a listed high-yield product. At Perpetual, we look at fixed-income markets from the perspective of credit being a key source of value-add. In our view, the underlying fundamental of credit premia is that they offer good compensation for risk in well-managed portfolios. Credit is a good way to add diversification to the defensive portion of portfolios, forming a bedrock which is all about capital stability, liquidity and regular distributions – while maximising potential return.

Australian investment portfolios are effectively among the most underweight to the fixed-income asset class of any market in the OECD. There is strong recognition that investors should have more exposure to fixed income and that this exposure should be in quality assets focused high in the capital structure of issuers.

Gaining access to assets in the high-yielding loan space is next to impossible for smaller investors. As the sector has grown, along with our own capabilities, we have received considerable reverse enquiry from investors who would like to access this asset class – particularly via the listed space which has been dominated by hybrid risk and is open to equity volatility.

We are an active fund manager, which allows us better to manage the risk in our portfolios while at the same time actively taking advantage of opportunities when there is volatility.

MOAL The last few years have seen a good, stable high-yield market develop with two ‘sleeves’ – of leveraged loans and high-yield bonds. A growing number of smaller companies, listed or unlisted, are looking to the bond market for alternate sources of funding to equity or bank loans.

The market is developing a track record with transactions from the likes of NEXTDC and smaller firms like Centuria Group and NRW Holdings. Firms like these are realising high-yield bonds form an important part of their capital structure and that this is a useful market to access.

KORBER It should be said that the product we are offering is not a high-yield trust per se. It is an unconstrained credit style of investment in floating-rate format, which we pioneered in Australia in 2012. Our approach realises that high-quality credit provides good compensation for risk and leads to a predictable return profile – provided it is sensibly managed and well diversified.

We also recognise that – as investors move out across the risk spectrum into high-yielding, subinvestment-grade bonds or unrated private loans – compensation increases quite generously but so does risk. We avoid pursuing strategies that have a predefined target for exposure to a higher-yielding part of the universe.

We build portfolios with a core investment-grade element in mind, using a barbell approach to provide repeatable, capital-stable characteristics in all market conditions. But there are opportunities to add value beyond this, by allocating into high-yielding opportunities on a deal-by-deal basis where such opportunities emerge.

The new trust will have a very diverse range of assets, which will be analysed according to risk relative to a core of investment-grade securities which will sit at a minimum of 30 per cent of the portfolio. This means we can be selective about the risk we take in the higher-yielding space.

"Australian investment portfolios are effectively among the most underweight to the fixed-income asset class of any market in the OECD. There is strong recognition that investors should have more exposure to fixed income and that this exposure should be in quality assets focused high in the capital structure of issuers."

How does this work on a day-to-day basis?

MOAL When we pursue high coupons, we want to make sure we provide capital stability and low volatility. We focus on leveraged loans or corporate bonds which are senior in the capital structure and often secured. These instruments are difficult for individual investors to access and help to diversify their portfolios from hybrids or shares.

We are looking for smaller companies that our investors may not be familiar with and that are subinvestment grade or unrated—but which have good-quality cash flows. We are mindful of being at the top of the capital structure so that if something goes wrong we will have claim on the first dollar. We do not put on large positions: even if we find a high-yield credit particularly attractive, the investment will not form more than 2-2.5 per cent of the overall portfolio.

We look for companies with a track record or management with a very strong execution track record, and we make sure they have tangible assets or a strong IP – so a real business with real value. We stay away from greenfield risk.

KORBER With debt investment, return is a contractual obligation to pay coupons and capital. The upside is locked in and the critical part of assessing an investment is to look at the downside. We therefore look at companies from a different perspective to the way that equity investors might.

Hence we focus on companies with good businesses that have strong cash-flow generation and, preferably, long histories. One of the crucial aspects of fixed-income investment is to manage the downside risk. If you do that well the upside largely takes care of itself.

It sounds like the part of the capital structure that the trust is in will be a major selling point in a market where a lot of investors regard their blue-chip equity investments as their de-facto income assets.

KORBER The current source of income for many investors is equity-based, either direct equity dividends or hybrid securities. There is nothing wrong with this per se, but hybrids have a high equity beta, being near equity, which could prove problematic in an equity market downturn.

An important characteristic of being at the top of the capital structure is that it gives the investor call on the first dollar of claim against the company’s value. The capital position is very secure provided there is a sufficiently large equity buffer underneath. Even in the leveraged-loan space, when companies fail the recovery rate is on average very high – in the 60-80 per cent range.

There is a place for a range of assets in investors’ portfolios. But there is an important risk characteristic that should be included: the capital-stable and defensive part. We think good-quality corporate bonds, senior-secured private loans and similar provide a good rate of return while not giving up the core attribute of being reliable assets in periods of market stress.

There is a strong recognition that investors need to have more of this and it is particularly true as the population ages and becomes more focused on retirement income. A recent study shows that investors with a core corporate bond holding within their portfolios can be more tolerant of market volatility.

In this context, how important might declining bank profitability or dividends be as a driver of investors looking for alternative income products?

KORBER Hybrids and bank shares are popular investments. In a sense we are the beneficiaries of good timing, given the talk of the impact on franking credits that may come with a change in government. I wouldn’t say this is focus for us, but it is driving closer consideration of investments in the income space.

How does a listed-trust format deal with the issue of liquidity that is problematic for mainstream institutional funds when it comes to asset classes like corporate and high-yield debt – specifically that end investors have committed liquidity in their allocations, but the underlying assets are not themselves liquid?

KORBER It changes where the liquidity is coming from. In unlisted product, liquidity comes from the sale of the underlying assets themselves. In an Australian Securities Exchange-listed product, it effectively comes from the market.

A listed-trust format allows us to make greater investments into assets like private loans, giving up some liquidity in the asset itself for the benefit of a good risk structure and positive returns. In this way, we can generate greater returns from the fixed-income asset class than we would if we had to keep more of the portfolio in cash or other highly liquid but lower-yielding assets.

"Five years ago, every private-equity firm with more than several hundred million dollars of loan-funding requirements would automatically go to the US market. By 2019, it is far less of a given that companies seeking high-yield funds will go straight to the US."

This is not the only recent trust start-up targeting high yield in Australia and the private-debt and institutional-loan market has received plenty of coverage of late. Do you think this growing profile and, presumably, assets under management will attract a wider range of borrowers?

MOAL There are more funds because the market is maturing including some well-established private-equity players regularly looking to the Australian debt markets for funding. Higher cost of capital has also driven banks to reduce their allocations to unrated or subinvestment-grade clients. This means there is real demand from borrowers for funding, which should attract more investors.

It also instils greater confidence in the local market. Five years ago, every private-equity firm with more than several hundred million dollars of loan-funding requirements would automatically go to the US market. We started to see Australian dollar tranches placed with Australian investors in around 2015. By 2019, it is far less of a given that companies seeking high-yield funds will go straight to the US.

KORBER We set up our first corporate bond fund in 1998 and at the time it was an uphill battle to generate investor interest in the asset class. However, in the past five years two of Perpetual’s top-three products by inflow have been fixed-income funds.

The investor market is also beginning to recognise that there is real value in the asset class. For any market to develop, you need assets and investors. Regulatory and market change has increased debt issuance, and the willingness of investors to take the opportunity seriously has also been a positive development.

In a growing market, investors can cast their net widely across the full breadth of the credit market, included offshore assets. There is an inherent advantage in this, which is that investing widely brings diversity and access to the liquidity of different global markets.

The trust is going to be diversified by country. Do you have a view on the likely domestic versus offshore split? The high-yield market in the US is clearly more mature and diverse, so why not just concentrate on US assets?

KORBER Our competitive advantage is in the Australian credit market. Our core investment universe is Australian issuers or offshore issuers in Australia, but we also look at these issuers on a global basis. Our competitive strength is knowing these issuers very well and making judgements around them, particularly in periods of market stress.

In a portfolio sense, we consider issues in different markets. But the majority of the assets will always be denominated in Australian dollars. The minimum domestic portion will be 70 per cent. As we have mentioned, it is an Australian dollar floating-rate portfolio and the opportunity set domestically has been good.

The advantage of this approach is that it allows us to be present in the markets we are familiar with and where we have competitive strength in analysing risk. In the loan space in particular, offshore assets are more challenging to hedge and introduce currency risk which can affect returns.

MOAL Although the US high-yield market is much larger than the Australian equivalent, we believe we have a competitive advantage locally. We are well positioned to analyse companies effectively and we have good access to domestic deals. We also believe that pricing in Australia has been attractive. We have developed a diversified portfolio of high-yield investments which nicely complement our suite of actively managed investment-grade assets.